Last week in Part 1 of this two-part post I discussed what an 83(b) election is and walked through one particular situation in which someone should make that election (hint: if the company is currently valued at or close to nothing). In this installment, I’ll go through an example in which it doesn’t make good financial sense to make that 83(b) election. In a world where many founders, entrepreneurs, and contractors working for equity are told to automatically file the election, this is the scenario to really pay attention to.
When it comes down to it, the whole idea of the 83(b) election is that you’re making a bet with the IRS that your company is going to continue to rise in value, while the IRS is betting that the company will fall in value. If the company increases in value, you’ve pre-paid your tax liability on a low valuation, you pay long term capital gains on any increase, and you’re a happy camper. However, if the company falls in value and you’ve prepaid your tax liability at a higher valuation than what you ultimately cash out at, then you’ve overpaid taxes. The hook in 83(b) is that the IRS then won’t let you claim those overpaid taxes on your next tax return (though you could get a deduction for the capital loss). Of course, in the same way that everyone thinks they’re above-average, everyone thinks that their startup is going to flourish and continue to rise in value. Recent studies, however, indicate that the failure rate is in the neighborhood of 75%.
Failure doesn’t always mean bankruptcy though, failure can mean a buyout at a lower valuation than expected. To show you what the tax implications of such a situation would be, I’ve created another handy graphic. In this situation, assume that a company just closed its Series A round and hired a new employee, who’s being paid partially with 1000 shares of stock subject to a two year vesting schedule, with an income tax rate of 33%.
In other words, if you’re signing onto a company and receiving equity once they’ve already got some value to them, you should think long and hard about whether or not to make that 83(b) election (though remember you only have 30 days to file from the date of the transfer). I’d recommend looking at the company as if it were another stock in your investment portfolio (which of course it is), and examine it critically; you’ll not only be outlaying time and effort with your work, you could potentially be outlaying a serious amount of money that isn’t recouped.
Which brings me to the final point to be aware of when deciding whether or not to make an 83(b) election: liquidity. That is, if you’re going to make an 83(b) election on unvested stock in a company that has a valuation above $0, you’re going to owe the IRS some money come April 15. Where it’s a large grant of stock, it could potentially be a great deal of money you owe on a volatile asset that you can’t access or transfer.
In conclusion, a quick recap for the TL:DR crowd: If you’ve received equity subject to a vesting agreement in a company with a very low valuation, it’s almost always going to make sense to take the 83(b) election because there will be a minimal payment to the IRS up front, a more favorable tax rate on any gains, and very low risk. If you’ve received equity subject to a vesting agreement in a company with a mid to high valuation (like a company that just raised its first round of funding), you’ve got a lot more to consider in determining whether to take the election, including the initial outlay to the IRS and the risk of a loss in value.